Herzfeld s Outlook: Seasonal Factors Provide Opportunities in Closed-End Funds

Transcription

1 VIRTUS HERZFELD FUND Herzfeld s Otlook: Seasonal Factors Provide Opportnities in Closed-End Fnds When it comes to investing in closed-end fnds, a comprehensive nderstanding of the inefficiencies of the market may lead to profitable reslts. Yet spotting attractive trading opportnities involves more than jst looking for the widest discont to net asset vale; nderstanding why a fnd sports a particlar premim/discont valation is mch more telling than the raw data itself. SPECIAL COMMENTARY November 2014

2 Tis the Season THE HERZFELD ADVANTAGE Thomas J. Herzfeld has devoted 46 years to the stdy of the closed-end fnd indstry, writing the first book on the sbject and prodcing ongoing research, while the advisory firm that bears his name has become synonymos with closed-end fnd investing. The Virts Herzfeld Fnd (VHFAX, VHFCX, VHFIX) is crrently the only activelymanaged retail investment company prodct that provides a way for investors to participate in the Herzfeld expertise. The Herzfeld Portfolio Management Team tracks a 574-fnd niverse, monitoring more than 20 variables that inflence fnd pricing and valation. The graphic below illstrates the variables and levels of expertise. One of the best-known proprietary trading strategies of Thomas J. Herzfeld Advisors, Inc. centers arond year-end trading activity. Pressres on share prices in the forth calendar qarter have historically tended to provide favorable investment opportnities, while the lifting of those pressres at the beginning of the calendar year may present profitable exit points. Forth qarter volatility has to do with tax planning. Investors typically look at their net realized gains coming into year-end, and may seek to redce potential tax conseqences by realizing offsetting losses. Fnds targeted for disposal tend to be the poor performers, and recent sector downtrns mean that selling pressre is expected to be concentrated in a few hard-hit areas. Following are three themes Herzfeld expects to present opportnities dring the forth qarter of 2014: 1. Energy Independence with a Payot 2. Look at the Losers 3. Mnicipal Fnd Year-End Trends Finding Opportnity Reqires Systematic Research Advanced Expertise Trading Volatility Declared Shareholder Stakes Expense Ratio Premim or Discont Income Ratio Distribtion Rate Correlation Analysis Performance Leverage Profile Trading Liqidity Management Reptation Portfolio Holdings Basic Expertise Intermediate Expertise Distribtion Policies Tax/Distribtion Implications of Loss Carryforwards Impact of Leverage on Common Shares Anti-Takeover Provisions Lifeboat Provisions Reglatory Concerns Vlnerability to Dissident Activity Corporate Governance Special Sitations Information that Reqires Extensive Analysis the Herzfeld Research Advantage 2

3 1. Energy Independence with a Payot Weak performance in the energy sector has pt a damper on the valations of Master Limited Partnership (MLP)-specialist closed-end fnds. Factors that have recently impacted valations inclde: renewed nrest in the Middle East, weak commodity prices and in particlar oil prices, as well as confsion over MLP pioneer and sector giant Kinder Morgan s Agst annoncement of its decision to abandon the MLP strctre. MLPs receive favored tax treatment and are available for investors to prchase on the stock exchange, althogh the tax treatment of these partnerships can be complex. As a reslt, individal investors may prefer to hold MLPs throgh investment companies, and the closed-end fnd wrapper has been particlarly poplar. Althogh both NAV and price performances have been strong, p % and %, respectively for the year-ended September 30, 2014, discont levels among MLP fnds widened throghot 2014, and disconts are now significantly more prevalent than premims. Average Discont of MLP-Focsed Closed-End Fnds 10% /31/12 1/31/13 2/28/13 3/31/13 4/30/13 5/31/13 6/30/13 7/31/13 8/31/13 9/30/13 10/31/13 11/30/13 12/31/13 1/31/14 2/28/14 Kinder Morgan annonces it will abandon its MLP strctre 3/31/14 4/30/14 5/31/14 6/30/14 > 7/31/14 8/31/14 9/30/14 10/28/14 ACTION ITEMS We believe the nderlying fndamentals for energy remain attractive going forward and, in particlar, that MLP financing is poised to fel mch needed energy infrastrctre growth in the U.S. We expect the grop to not only retrn to favor bt to gain in poplarity. Investors, nervos abot the potential for increases in interest rates, contine to look for ways to replace income investments. The average distribtion rate paid by the MLP fnd grop is crrently 6.2% and many individal fnds within this P/D grop have systematically increased their payots.* We like MLP-focsed closed-end fnds as a long-term investment and seek to take advantage of year-end weakness in the sector Sorce: Bloomberg and Thomas J. Herzfeld Advisors, Inc. Past performance is no garantee of ftre reslts. * Some MLP-specialist fnds are taxed at the fnd level while others are not, with the distinction based on whether more or less than 25% of the nderlying portfolio is comprised of MLP investments. In addition, pre MLP fnds typically pay a majority of their distribtions from retrn of capital. 3

4 2. Look at the Losers ACTION ITEMS Senior loan fnds had been investors favorites ntil mid- 2013, when average premims inverted to average disconts. Valations remained weak throghot year-end 2013 then rebonded somewhat in early Since then, however, disconts have steadily widened and at crrent levels, with an average discont to NAV of more than 8%, we consider the grop to be attractive. Most investors that boght fnds in this sector at the beginning of the year now have losses, making the grop ripe for tax loss harvesting. We expect this to reslt in frther price weakness throgh yearend with potential opportnities to add to or holdings. Senior loan fnds hold loans which are senior in the capital strctre of the company taking the loan. Interest payments are variable and reset based on short-term interest rates, typically pegged to LIBOR (London Interbank Offered Rate). When short-term rates rise, the income the senior loan fnds take in increases and vice versa. There are three technicalities that come into play. 1. There is a lag of p to several months between a rise in short-term rates and when the interest rate on the fnds nderlying loans reset. 2. A large percentage of the nderlying loans have LIBOR floors, which means that if LIBOR declines below a certain level, the interest payment de from the borrower does not reset lower. This has been good for investors as interest rates have declined, bt it means that income on these loans will not increase ntil LIBOR breaks throgh the floor on the way p. 3. Closed-end senior loan fnds are typically leveraged with instrments whose interest rate also resets based on LIBOR. There are typically no floors or similar constraints on the cost of leverage, so as interest rates begin to rise, the cost of leverage can be expected to increase, potentially reslting in distribtion cts. In fact, there have already been redctions in their distribtion rates this year, and this has contribted to widening disconts for the grop. The average distribtion rate for senior loan fnds as of September 30, 2014 was 6.66% while the grop is valed at an attractive 8.57% average discont level. Average Discont of Senior Loan Closed-End Fnds 8% Poor performance and distribtion cts have pt pressre on senior loan fnd valations all year /31/12 1/31/13 2/28/13 3/31/13 4/30/13 5/31/13 6/30/13 7/31/13 8/31/13 9/30/13 10/31/13 11/30/13 12/31/13 1/31/14 2/28/14 3/31/14 4/30/14 5/31/14 6/30/14 7/31/14 8/31/14 9/30/14 10/28/ Sorce: Bloomberg and Thomas J. Herzfeld Advisors, Inc. Past performance is no garantee of ftre reslts. 4

5 3. Mnicipal Fnd Year-End Trends In good years and bad, closed-end fnd mnicipal fnd investors can be conted on to be sellers at year-end. Last year, the grop was especially hard hit after trning in losses, then rebonded early in For the first nine months of this year, helped by falling interest rates, the average NAV of a fnd in the mnicipal grop was p 15.16% with share price p 14.06%; the difference reflecting widening disconts. In spite of the good retrns, investors contine to be concerned abot the ftre. Mnicipal fnds had their share of dividend cts in 2014 and more cts are expected as the extended low interest rate environment filters throgh as lower earnings for bonds in the fnds portfolios. ACTION ITEMS We have been taking some profits recently, raising cash for seasonal bying opportnities shold the expected year-end weakness occr. We plan to favor those mnicipal fnds with dobledigit disconts. The chart below shows how disconts have been steadily widening. We expect pressre on share prices to contine. Taking a short-term time horizon, we will seek to be sellers again early next year. Average Discont All Tax-Exempt Mnicipal Closed-End Fnds 8% There has been steady discont widening, in spite of strong gains throgh October. Average Discont /31/12 1/31/13 2/28/13 3/31/13 4/30/13 5/31/13 6/30/13 7/31/13 8/31/13 9/30/13 10/31/13 11/30/13 12/31/13 1/31/14 2/28/14 3/31/14 4/30/14 5/31/14 6/30/14 7/31/14 8/31/14 9/30/14 10/28/ Year-end 2013 was a good example of typical discont trends for this grop Sorce: Bloomberg and Thomas J. Herzfeld Advisors, Inc. Past performance is no garantee of ftre reslts. > FLASH SALES One last thoght with the flrry of year-end trading activity, nexpected bargains are often created by pockets of nsally aggressive selling, particlarly in more illiqid fnds. We keep a watchfl eye for sch opportnities, as they are typically gone in a flash. 5

6 UNDERSTANDING THE DISCOUNT Unlike with open-end mtal fnds, closed-end fnd investors mst keep an eye on two metrics, net asset vale (NAV) and share price. A closed-end fnd s NAV can and does move independently of its share price, with the difference measred as a premim, if share price exceeds NAV; or a discont, if share price is below NAV. The premim/discont valation is a tangible measre; however, many investors want to know when a discont is wide enogh to be attractive. After all, some fnds tend to habitally trade at disconts, while others rarely do. To answer this, the Herzfeld Portfolio Management team points to a few basic tenets: It s a poplarity contest Independently moving parts Watch the headlines Magnified reaction Historical barometer Watch the peers Don t fear the discont Finally, don t be greedy At the core, discont/premim valation has to do with spply and demand. Remember that, as the name indicates, closed-end fnds have a closed capitalization, in other words, a limited spply. The nmber of shares issed in the initial pblic offering are fixed (with only a few ways to add otstanding shares after the IPO.) That means that when the investment area is in demand, there will be more byers than sellers, and disconts will narrow or the fnd may trade at a premim. If the sector is ot-of-favor, disconts will widen ntil poplarity retrns. Another fndamental featre of the closed-end strctre is that fnds trade on the stock exchange. This means net asset vale performance, a measre of the sccess of the portfolio manager, may differ from share price performance, which can often be inflenced by sentiment or other factors. Indeed, year-end tax selling is one sch factor, ptting added selling pressre on the closed-end fnd s share price while the NAV cold actally be improving. Bad news tends to have an immediate impact on closed-end fnd pricing as investors rn for the exits, often before flly assessing the impact the news will have. The MLP discssion is an example of this, bt the effect can be more fnd-specific. For instance, distribtion cts often bring in sellers and provide attractive bying points. Many closed-end fnds se leverage to boost the income available to the common shareholders, bt leverage magnifies performance making good performance better and bad performance worse. The NAVs of fnds with more leverage tend to be more volatile, and share prices of fnds with more volatile NAVs tend to have larger discont/premim swings. One way to determine if a crrent discont level is excessive is to compare it to the fnd s historic discont level. Focs on bying and selling a fnd based on the statistical significance of deviations from its own historical premim/discont levels. For example, a fnd with a five percentage point widening may be worth considering as a by; while after a five percentage point narrowing, we wold evalate whether it is time to sell. If there are fnds with similar objectives or areas of specialization, see how the fnd s discont compares. If it is significantly wider or narrower that its peers, try to pinpoint why. If there is no good reason for a wider discont, the fnd may be ripe for prchase. A theme among or most sccessfl strategies is contrarian investing. We by when the discont becomes attractive, and keep bying if the discont keeps widening, averaging down. The relatively small capitalization of some fnds means that it tends to be easier to by than sell. Don t wait for a home rn. Start lightening p on yor holding as the discont narrows, selling into strength. 6

7 To learn more abot the Virts Herzfeld Fnd A: VHFAX, C: VHFCX, I: VHFIX contact yor financial advisor or visit Virts.com. IMPORTANT RISK CONSIDERATIONS Closed-end fnds may trade at a discont from their net asset vales, which may affect whether the fnd will realize gains or losses. They may also employ leverage, which may increase volatility. The market price of eqity secrities may be affected by financial market, indstry, or isser-specific events. Focs on a particlar style or on small or medim-sized companies may enhance that risk. Debt secrities are sbject to varios risks, the most prominent of which are credit and interest rate risk. The isser of a secrity may fail to make payments in a timely manner. Vales of debt secrities may rise and fall in response to changes in interest rates. This risk may be enhanced with longer-term matrities. Investing internationally, especially in emerging markets, involves additional risks sch as crrency, political, acconting, economic, and market risk. U.S. government secrities may be sbject to price flctations. An agency may defalt on an obligation not backed by the United States. Any garantee on U.S. government secrities does not apply to the vale of the fnd s shares. Becase the fnd can invest in other fnds, it indirectly bears its proportionate share of the operating expenses and management fees of the nderlying fnd(s). For additional information on these and other risk considerations, please see the fnd s prospects. Leverage: The se of borrowed capital to increase the potential retrn of an investment. While leverage magnifies both gains and losses, it comes with greater risk. A leveraged portfolio can sffer greater losses than a non-leveraged portfolio. The commentary is the opinion of the sbadviser. This material has been prepared sing sorces of information generally believed to be reliable; however, its accracy is not garanteed. Opinions represented are sbject to change and shold not be considered investment advice or an offer of secrities. 7

8 VIRTUS HERZFELD FUND Investors shold careflly consider the investment objectives, risks, charges, and expenses of any Virts Mtal Fnd before investing. The prospects and smmary prospects contain this and other information abot the Fnd. Please contact yor financial representative, call , or visit to obtain a crrent prospects and/or smmary prospects. Yo shold read the prospects and/or smmary prospects careflly before yo invest or send money. Not all prodcts or marketing materials are available at all firms. Not insred by FDIC/NCUSIF or any federal government agency. No bank garantee. Not a deposit. May lose vale. Mtal Fnds distribted by VP Distribtors, LLC, member FINRA and sbsidiary of Virts Investment Partners, Inc Virts Investment Partners, Inc.